Why a buy-the-dip stock-market strategy is inferior to buy-and-hold

AnoraMahmudova

Buying stocks on dips to earn extra return then switching to cash to wait for another pullback sounds like a good strategy. After all, buying low and selling high is what investors are told they should do.

But investing only on the dips, which involves some market timing, returns far less than simply buying and holding, according to Samuel Lee, investment adviser at SVRN Asset Management.

To prove it, Lee ran simulations using monthly U.S. stock market total returns from mid-1926 through the end of 2016.

Under one simple version of the buy-the-dip strategy, an investor would wait for a correction—a peak-to-trough decline of 10%—before buying. The investor would then hold the stocks for at least 12 months or until the market recovers to the point where the investor bought the stocks, whichever is longer.

“This strategy would have put you in cash about 47% of the time, so if our switches were random, we’d expect to earn about half the market return with half the volatility,” Lee wrote.

Instead, it turns out the buy-the-dip strategy would earn a third of return of a buy-and-hold strategy with much higher volatility.

In the chart below, Lee maps out the cumulative excess return (that is, return above cash) of this variation of the strategy versus the market.

Breaking down the cumulative return to average annualized returns with corresponding volatility shows you just how bad of a strategy buying the dip would have been.

Volatility in this case measures how far actual returns deviate from the mean. A standard deviation of 10%, for example, means that two thirds of the time, returns could range from 10% below or above the average return.

Buying and holding equities over this stretch of time returned 6.4% annualized, but with a standard deviation of 18.6%, meaning that returns in any given year could range from negative 12.2% to positive 24%.

Timing the market to buy only after a 10% decline would have returned 2.2% annualized but with a much greater volatility of 15.7%. The range would be negative 13.% to positive 17.9%.

For comparison, the annualized return for a 10-year Treasury note
TMUBMUSD10Y, +0.03%
since 1926 was about 5.3% with a standard deviation of 5.7%.

A perfect example would have been to be 100% in cash by October 2007 and then wait until March 2009 to get back into stocks at the bottom.

But Lee found that a rule in which an investor waits for a 40% to 45% crash before buying and then holds for five years would only reap half the market return while remaining in cash two-thirds of the time since mid-1926.

Lee gives two possible reasons why the correction-timing strategy fails in the long run.

First, sitting in cash when the historical equity risk premium—excess return above a risk-free rate, such as the yield on a Treasury note—was high and bear markets rare would be costly.

The second reason has to do with market momentum: “The market tended to exhibit momentum more than mean reversion over yearslong horizons,” Lee wrote.

Or on a variation of the words often—and likely apocryphally—attributed to John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.”

“As strange as it sounds, you would have been better off buying when the market was going up and selling when it was going down, using a trend-following rule,” Lee concluded.

Lee is careful, however, to urge that his findings not be construed as advice to always buy and hold. Instead, he argues simply that a “mechanical strategy of waiting for a crash on average resulted in much worse absolute and risk-adjusted returns than buying and holding.”

Providing critical information for the U.S. trading day. Subscribe to MarketWatch's free Need to Know newsletter. Sign up here.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.